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The active nature of passive funds

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When people talk about the ‘passivity’ of index-tracking funds, there is a belief that a passive fund is run by some robot in a silo surrounded by banks of computer servers that never sleeps, eats, needs a toilet break and has no emotional input. The fund just dispassionately follows the index and reflects its performance rain or shine. But people may be surprised that passive investing isn’t as passive as they think.

First up, let’s just get the basics out of the way. There are two management styles for investment funds: Active and Passive. An active manager is usually a human being, supported by teams of human analysts who take their client’s money and invest it on the stock exchange following a personal or house investment style (I will do a piece about style and style analytics further down the road). According to their research, which includes talking to the management, visiting their company to see what they do and how they do it, analysing the financial data of the company from all sorts of angles, and assessing how it compares or contrasts to market data, the fund manager will make an active decision to buy that company’s shares and trade it in line with their style and research.

Active managers assure us that they can beat the market – and thereby offer better-than-expected portfolio returns, because they have the special sauce that they can dollop on their magic beans to make them grow better. Of course, all those banks of analysts, traders and compliance experts don’t come cheap. Neither does travel. And in the current environment, neither does keeping the lights on and heating an office in the middle of London (especially if you keep them on all night like some firms do in Canary Wharf). And so, the active fund manager charges a fee to cover their costs, will often charge dealing fees and if proved right (in being a bit better than the average – or median – fund manager, who is aiming to just outperform the index they are following) will charge a performance fee.

However, you have also got to consider that the manager, like everyone else, is motivated by the levers of fear, greed, FOMO; can catch Covid-19; might forget their sister’s birthday, or have to look after a sick toddler; or might just be terribly hungover from celebrating a new client win the night before. This will have an effect on the timing of trades or selecting investments poorly.

Lack of humanity

Passive fund management tries to take that ‘humanity’ and that cost out of the mix. The index fund tries to match the performance of the index it is tracking. It never really achieves this, as no one has designed a perfectly efficient system, and after management fees are deducted (presumably for the diesel and electricity) the index tracker often underperforms the market it is tracking. However, it is much cheaper, and if you view an index as ‘risk-free’, much less risky and more accurately tracking of the general direction of travel of the market.

Exchange Traded Funds, or ETFs, have become very popular since the first, the SPDR S&P 500 ETF, was launched in 2003. They too track an index, but can also track a geography (for example, Africa), a sector (for example, technology), or a single commodity (for example, gold) or a combination of them all.

In many ways it’s very hard to be ‘above average’ in a market, especially if you are the market. Basic mathematics can tell you that 50% of all funds will be ‘below average’, so by being as close to average as possible, you can be ‘better’ than 49% of all funds in existence. Statistically (when fees and expenses are taken into account) most passive funds will outperform active funds over the long term.

This isn’t going to be an article on the benefits of active versus passive fund management styles. The Armchair Trader recently pricked that boil here.

Actively passive

However, the common conception of a passive fund being a bank of servers in some hanger in the Nevada desert isn’t entirely accurate. In reality, managing a passive fund isn’t just a case of flicking a switch and the fund will then magically run itself, as there are real life issues to deal with, like dealing costs and taxes, and if these are not managed, they can really impact the performance of an investment fund.

In reality, running a passive fund is far from smooth. A stock market index can’t and doesn’t take into account real trading issues like dealing costs or taxes. If left unchecked, these factors can leave a fund’s performance significantly trailing behind the index.

This needs the oversight of portfolio managers who will manage the risk to the portfolio from tracking error, which is the divergence of the fund from the benchmark it follows. When, for example a new company comes into the index, or drops out, the passive fund must buy and sell its shares to balance its exposures and track the index.

Man v. Machine

However, with over 35% of all money invested in the stock markets in passive funds, that’s a lot of bots trying to buy shares at the same time, which can affect price and performance. Moreover, the act of buying and selling incurs cost and capital gains taxes, which come out of the fund’s performance. This is when in the Man versus Machine contest, man often has the primacy, as a human can make decisions on timing that can lessen the impact of a trade.

These humans are like a sea captain in a hurricane, always trying to drag their ship back on course, and have to react quickly to deal with market events – market events are after all often driven by human behaviours, like a new Prime Minister being appointed or a head of state dying.

They can use technology to help flag up tracking error variations, or program in changes they think are going to happen, so that the system can react to news, such as a rise in the base rate. There are also ways of organising the portfolio – in an easily traded index, a manager might try to replicate all the stocks in that index and hold them in the right proportions. However, in a less elastic market, like AIM, it is sometimes difficult to exit or enter individual stocks due to liquidity issues (not enough buyers for the sellers in the market), and so they will try to partially-replicate the index.

Managers will use derivates a lot in index funds to replicate the performance of the investment, without actually buying the investment, and can be more cost-effective than dealing constantly in small illiquid investments. While automation is possible for many processes, the key task of a passive fund manager is to ensure that data and ultimately fund risk is accurate. This requires a systematic and detailed process to identify exceptions and then rectifying them.

ETFs are even more ‘actively passive’ than index funds. To start with, the creation of a basket index for an ETF to trade is an active decision by a human being. ETFs are decisions made by people depending on their own qualitative perspectives.

There is no black and white between active and passive. Many active fund managers need to track an index to an extent or else they will be a long way off the median, and should something extraneous happen, if they are a long way from safety, the negative results of their active decisions can really affect the whole fund.

Likewise, passive funds have an active, human component involved. We haven’t yet reached the point where all investment decisions are automated. Technology moves very quickly, but the need to have flesh and bone somewhere in the process will be with us for a long time.

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This article does not constitute investment advice. Make sure you do your own research or consult a professional advisor.

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